The Texas-sized bankruptcy of Energy Future Holdings, formerly known as TXU, may have been one of the more anticipated defaults of the past few years, but investors can still learn a lesson or two from it.

First and foremost, it underscores the perils involved when investors rely too heavily on high-yield, floating-rate bank loans, a popular strategy for those seeking high returns and protection against rising interest rates.

The roots of this story stretch back to 2007. That’s when the Dallas-based power company was taken private, for $48 billion, in what is still the largest leveraged buyout (LBO) in history. At the time, yield spreads were extremely tight, prompting buyers to reach for higher returns. That demand helped finance a surge in LBO activity.

As we know now, 2007 turned out to be the peak of that LBO boom, and TXU was one of the last and most aggressive transactions of the year. Its weight in major bond and loan benchmarks ensures that its default will roil many portfolios.

Money Pours into High-Yield Bank Loans

Flash forward to the present: Tight yield spreads on corporate bonds once again have investors hungering for higher returns. LBO activity is heating up again. And with today’s low interest rates expected to rise, floating-rate loans are in demand.

Since 2012, investors have poured $82.5 billion into high-yield leveraged loans, which are often used to finance buyouts. That’s nearly three times what investors have put into the much larger high-yield bond market, J.P. Morgan data show. That has caused assets managed by leveraged loan funds to rise sharply (Display).

This high demand is creating sketchy supply. It allows companies with fragile credit profiles to borrow cheaply and dulls their incentive to offer much in the way of protection for lenders.

The term to watch out for here is “covenant-lite.” Most loans have built-in covenants—safeguards that limit how much debt a borrower can issue. These safeguards allow lenders to negotiate higher rates if debt limits are breached. Covenant-lite loans don’t have these.

Higher Covenant-Lite Issuance Raises Risk

According to data from J.P. Morgan and S&P, covenant-lite issuance more than tripled last year, accounting for more than half of all high-yield loans issued. In the first three months of 2014, covenant-lite loans comprised two-thirds of total issuance.

That suggests that the risks associated with holding loans are increasing. Indeed, the default rate on high-yield loans has been substantially above that of high-yield bonds for most of the past five years. Energy Future Holdings’ default will widen the gap further.

What’s more, despite investors piling into high-yield loans, the performance of those loans has come up short. Bonds have outperformed loans for the last five years straight, according to Barclays, providing investors with a cumulative return of 145% through March 31, compared with 100% for loans.

Being Senior Isn’t Everything

A perceived advantage of bank loans is their seniority in a firm’s capital structure. In other words, if a company defaults, lenders recover more of their investment than bondholders do.

But sometimes, being first in line isn’t much to cheer about. The loans at Energy Future Holdings’ Ca-rated wholesale power distributor have lost about 25% in value, indicating that the market expects investors will suffer a significant loss. Sure, bondholders in that same business unit will fare worse. But high-yield bonds issued by a separate subsidiary of the company are trading at a premium. Put another way, senior isn’t always superior.

Even loans’ floating-rate appeal is misleading. The coupons on many loans won’t adjust upward until thethree-month LIBOR more than quadruples—to exceed one percent. Futures markets suggest that we’re a long way from that point.

A Possible Alternative to Yield Chasing

So what can investors do differently? We think it makes sense to consider short-duration, high-yield bonds. They may help shield investors from the risk of rising rates while limiting exposure to the many credit-related pitfalls that dot the investment landscape. Bank loans can still play a role in a diversified fixed-income portfolio. But it pays to be careful.

Energy Future Holdings got into trouble when it bet that natural-gas prices would rise—and got it wrong. Nobody knows what might trigger problems for the next heavily leveraged borrower. That’s why investors can’t afford to buy without peering under the hood first.